Regulated utilities have long been a staple for many retired investors living off dividends.
However, while most people think of this industry as one that generally consists of high-yield, slow but steady dividend growth, that isn’t always the case.
In fact, Dominion Resources (D) is one of the fastest growing regulated utilities you can own, with an exceptional management team that is making all the right moves to continue putting up industry-leading safe and sustainable dividend growth for years to come.
Besides relatively impressive income growth, Dominion Resources’ dividend has been extremely reliable. The company has paid consecutive dividends for nearly 90 years.
Let’s take a look at Dominion Resources and its 4.1% high yield for consideration in our Conservative Retirees dividend portfolio.
Founded in 1909 in Richmond, Virginia, Dominion Resources is one of America’s largest diversified utilities. The company makes money by producing and transporting energy.
After acquiring Questar, a major natural gas distributor, in late 2016, the combined company serves 2.5 million electric utility customers and 2.3 million gas utility customers in seven states.
Dominion Resources operates via three business units:
Dominion Generation (40% of 2016 EBITDA): Owns all of the company’s power generating facilities, including its merchant power division and the renewable energy fleet, which sells power to other utilities under long-term power purchase agreements (PPAs).
Dominion Virginia Power (25%): Provides power to over 6 million customers in Virginia and North Carolina.
Dominion Energy (35%): Operates the utility’s natural gas business including: 14,600 miles of natural gas pipelines to provide natural gas to customers in Ohio, West Virginia, Utah Wyoming, and Idaho, as well as over 1 trillion cubic feet of gas storage capacity.
This segment also acts as the general partner and sponsor of Dominion’s midstream MLP, Dominion Midstream Partners (DM), which provides a tax efficient, low cost funding method for the company’s ambitious natural gas growth plans. That includes such mega-projects as the Cove Point LNG export terminal and Atlantic Coast Pipeline.
While the majority of the company’s revenue and earnings are derived from Dominion Generation, don’t let that scare you into thinking that the company’s revenue and earnings aren’t derived from secure sources.
Roughly 80% of Dominion Generation’s revenue is based on regulated prices. In fact, over 90% of Dominion’s overall sales are from its regulated business, with the rest mostly coming from long-term power purchase agreements.
In other words, Dominion’s revenue, earnings, and cash still are quite stable, and yet, fast growing compared to its peers.
At first glance, Dominion Resources appears to be a classic blue chip utility with a growth problem. However, that is a bit misleading because of two main reasons.
Specifically, management has made enormous efforts in recent years to branch out into faster growing businesses, particularly the highly profitable natural gas distribution business.
For example, take Dominion Resources’ $6 billion acquisition of Questar, a Rockies-based integrated natural gas distribution company. This deal gave Dominion better balance between its electric and gas operations while also improving the company’s scale and diversification by geography and regulatory jurisdiction.
In addition, the company has seen its depreciation, which suppresses EPS, rising rapidly as it invests in numerous multibillion dollar growth projects, including the $5.0-$5.5 billion Atlantic Coast Pipeline (of which it owns a 48% stake) and $3.8 billion Cove Point LNG export terminal.
These growth efforts are already starting to bear fruit with recent revenue and earnings growth proving to be among the best in the utility industry.
As you can see, Dominion also has a remarkable track record of not just maintaining impressive margins (for a regulated utility), but also growing aggressively without sacrificing profitability.
In fact, Dominion’s profitability is among the best in the industry, thanks largely to management’s disciplined approach to investing shareholder capital only into lucrative ventures that fit within its circle of competence.
|Utility||Operating Margin||Net Margin||Return On Assets||Return On Equity||Return On Invested Capital|
In addition, Dominion benefits from a friendly regulatory environment in its core Virginia and North Carolina electric markets.
That’s thanks in large part to the fast growth rate in these states, which causes regulators to want to incentivize heavy capital spending into expanded infrastructure through higher-than-average allowed returns on capital, as well as increasing electric rates over time.
Better yet, management’s plans for the future include some of the most ambitious growth plans in the industry, with as much as $20 billion in growth capital spending planned through 2020.
Much of this investment is going into the natural gas side of the business, which is where Dominion’s midstream MLP comes in.
Dominion Resources is the general partner and sponsor of Dominion Midstream, which means that, in addition to owning 64.6% of its limited units, it also owns the highly lucrative incentive distribution rights or IDRs.
These rights grant it a growing share of the MLP’s marginal distributable cash flow (MLP equivalent of free cash flow) as its distributions increase over time.
More importantly, Dominion is able to sell or “dropdown” its midstream assets to Dominion Midstream Partners, which raises funds from external debt and equity markets. This allows Dominion to recoup the costs of constructing these valuable, long lived, and cash flow rich assets.
Since Dominion retains a massive stake in Dominion Midstream, the vast majority of the cash flows from these assets end up right back in its coffers, able to fund further growth initiatives.
All told, Dominion Resources expects that its many growth catalysts will be able to generate long-term operating earnings growth of 6% to 8%, which will support dividend growth of at least 8% starting in 2018.
There are several risks to be aware of with Dominion Resources.
First, while its cash flow is highly stable, there is still some commodity risk, as seen with the recent negative guidance regarding the hedged positions it has at its Millstone Nuclear Power plant in Connecticut.
Specifically, lower clean energy credits are expected to decrease 2017 EPS by around 15 to 20 cents (about 5% of total EPS). In addition, lower natural gas prices and reduced solar tax credits will result in a decrease in operating earnings in 2017.
None of these issues seem like risks to Dominion’s long-term earnings power, and fortunately, the growth initiatives coming online in 2018 should results in EPS growth of at least 10%.
However, the relatively weak guidance for 2017 has already resulted in some share price weakness, resulting in another potential risk.
Specifically, because Dominion occasionally uses its shares to pay for acquisitions (as well as fund some of its growth projects), the company’s growth is somewhat at the mercy of its share price.
Meanwhile, its largest source of funding, Dominion Midstream, is far more exposed to this risk because its high-payout business model requires it to continually raise equity capital from investors.
In other words, in the event of really weak share prices, Dominion could find itself with insufficient liquidity to fund its aggressive growth plans.
This is especially true in a rising interest rate environment, for two reasons. First, higher interest rates mean higher debt costs, and thus rising overall capital costs.
Additionally, rising interest rates on risk-free assets, such as 10- and 30-year U.S. Treasuries, mean income investors might not be as desperate for high-quality bond alternatives as they have been in the last decade.
That could further reduce the amount of cheap equity capital Dominion has access to, resulting in slower than expected growth in sales, earnings, and the dividend.
Dividend Safety Analysis: Dominion Resources
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Dominion Resources has a Dividend Safety Score of 90, meaning its dividend is highly secure and dependable.
That’s not surprising given that Dominion Resources is a dividend achiever, with 13 consecutive years of payout growth under its belt (including during the 2008-2009 financial crisis).
Dominion’s reliable dividend is courtesy of two important factors. First, management generally maintains a safe payout ratio (for a utility), which ensures that the payout is well covered by earnings.
For example, even with management’s guidance of $3.40 to $3.90 for 2017 earnings, Dominion’s 2017 dividend payout ratio should come in at 79% to 89%.
Keep in mind that for regulated utilities, a payout ratio between 80% and 85% is generally considered safe due to the stable nature of utilities’ earnings and cash flow. The utility business is highly capital-intensive, so these metrics need to be looked at in context.
As you can see below, Dominion Resources’ EPS payout ratio has generally remained around 70% to 80% most years.
The other important dividend safety factor to consider is Dominion’s balance sheet. As with most utilities, Dominion has a large amount of debt. However, don’t let the apparent high leverage ratios fool you.
When we compare the utility’s debt burden to its industry peers, we can see that Dominion, while indeed having a lower current ratio, isn’t actually more leveraged than most other utilities.
|Utility||Debt / EBITDA||EBITDA / Interest||Debt / Capital||Current Ratio||S&P Credit Rating|
Source: Morningstar, Fastgraphs
Most importantly, management’s plans to strengthen the balance sheet via massive drop downs to Dominion Midstream in the coming years has resulted in it having a strong investment grade credit rating with stable outlook from both S&P and Moody’s.
As a result, the utility should have little trouble refinancing its debts in the coming years, and its current operating earnings are more than sufficient to service its interest payments.
Dominion also has $5.5 billion of credit facilities and available liquidity (e.g. cash, short-term investments) of $2.4 billion.
To put it another way, Dominion is at little risk of having to cut its dividend in order to service its liabilities.
Dividend Growth Analysis
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Dominion Resources has a Dividend Growth Score of 53, suggesting its dividend growth potential is average (the market’s long-term dividend growth rate is about 6%). However, there could be some strong growth acceleration in the coming years.
Dominion has a solid track record of increasing dividend growth over time, and management remains confident that it will be able to deliver payout growth in excess of 8% once its growth projects start reaching completion in 2018 and 2019.
If Dominion Resources can indeed grow its dividend at a long-term rate of 8-9%, the stock could deliver annual total returns for shareholders between 12-13% (4.1% dividend yield plus 8-9% annual earnings growth).
That would top the market’s historical 9.1% annualized total return, especially when you consider Dominion’s low beta of 0.25, which indicates that its stock has been meaningfully less volatile than the market as a whole.
A big concern of many income investors right now is valuation, which is understandable given that the market is about to begin its 9th year of an epic bull run.
While Dominion Resources has underperformed the S&P 500 by nearly 20% over the last year and trades at a relatively high dividend yield compared to its long-term median yield, the stock’s trailing P/E multiple of 21.9 feels rather steep.
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It’s true that Dominion Resources is a grade-A utility with stellar profitability and a long growth runway ahead of it. Companies like this usually trade at a premium to the broader market, and Dominion is no exception.
Dominion Resources’ current valuation doesn’t seem to be a bargain, but given the company’s long-term growth prospects, the stock is probably about reasonably priced.
Closing Thoughts on Dominion Resources
Utilities are generally thought of as low risk (i.e. low volatility), high-yield, slow growth stocks that continue gradually chugging along each year. Many risk averse income investors, such as retirees, love to make them core holdings in their dividend portfolios.
Dominion Resources offers most of the traditional benefits of the utility industry but also one of the top long-term growth prospects in the sector as well.
That makes Dominion Resources an appealing core holding for many investors looking for strong income now or safe payout growth for the future.